Recent years have witnessed unprecedented levels of accounting
irregularities and scandals, leading to a thorough re-examination of
governance practices and the institutionalization of mandated governance
and accounting standards such as those incorporated in the
Sarbanes-Oxley Act. Left unanswered by all of the publicity and
legislation is the question whether the phenomenon has been fully and
properly understood. Although agency theory (Fama and Jensen, 1983;
Jensen and Meckling, 1976) speaks to the issue of monitoring and control
of executive discretion, do we know enough about how governance
structures operate in different contexts to be confident that we can
reduce the incidence of problems such as misleading disclosures?
We seek to contribute to our understanding of the dynamics of the
disclosure process and effective governance design by examining the
response of CEOs to threats to their employment capital and the
relationship between the board and the CEO. To date, the majority of
published research on misleading disclosures has appeared in the
accounting literature and focuses rather narrowly on audit and
litigation issues (e.g., St. Pierre and Anderson, 1984; Stice, 1991).
More recently, work investigating misleading disclosures has started
appearing in the management literature (e.g., Dunn, 2004; Latham and
Jacobs, 2000; Reed et al., 2004). Like this emergent research, our work
is grounded in management thought rather than accounting theory and
practice. We draw primarily on agency theory (e.g., Fama, 1980; Jensen
and Meckling, 1976) to focus on the tension between managerial
motivations and the ability to control managerial decision making. In
short, this research adopts more of a governance perspective than a
broad behavioral approach. Although we apply prospect theory (e.g.,
Kahneman and Tversky, 1979)--a behavioral framework--we do so within the
context of the agency relationship.
Understanding the framework presented here also necessitates a
brief recapitulation of agency theory, particularly as it relates to the
problem of misleading disclosures. In the modern corporation, the
separation of ownership from management results in an efficient division
of labor and differential risk-bearing in which shareholders, as
risk-bearing specialists, can reduce their exposure by diversifying
their portfolio of securities, while managers, who have skills in
formulating and implementing strategy, seek to maximize returns within
individual companies (Berle and Means, 1932). This separation of roles
implies that the interests and motives of owners and managers can
diverge, thereby giving rise to an agency problem (Fama and Jensen,
1983; Jensen and Meckling, 1976). Because they cannot diversify their
employment capital (Fama, 1980), managers may have positive incentives
to pursue strategies and make decisions that are suboptimal for
shareholders (Eisenhardt, 1989; Lee and O'Neill, 2003).
The inability of managers to diversify employment capital leads to
two critical considerations relevant to the disclosure process. First,
any impairment of employment capital necessarily will be borne directly
by the managers concerned. Thus, the value of their employment capital
will fluctuate with reported results, and disappointing or below-target
outcomes will decrease its value. Second, given this relationship
between performance and employment capital value, board oversight of the
disclosure process is crucial. Indeed, theorists generally advocate
strengthening the role and power of the board of directors in order to
mitigate the agency problem (e.g., Deutsch, 2005; Fama and Jensen, 1983;
Walsh and Seward, 1990; Zahra et al., 2005). In the context of
misleading disclosures, the board's proximity to management, and
its ability to review strategy and performance on an ongoing basis,
gives the board the greatest likelihood of discovering and correcting
any misbehavior. (Shareholders, even large ones, are external to the
disclosure process and may not be able to uncover problems.) However,
the board's success in doing so often depends upon the balance of
power between the board and the CEO. Hence, we focus here on managerial
employment capital concerns and the board's ability to monitor and
control the disclosure process.
The article begins by developing the theoretical framework for our
investigation of these issues. We review the linkage between firm
performance and the CEO's employment capital, and continue by
examining both the power of the CEO relative to that of the board and
the board characteristics likely to contribute to effective control.
Thereafter, we present the methodology and results of the study, and
conclude by discussing the implications of our findings and offering
suggestions for future research.
THEORETICAL DEVELOPMENT AND HYPOTHESES
Firm Performance and Threats to Employment Capital
Because managers cannot diversify their employment capital, the
value of that employment capital necessarily becomes intertwined with
the performance or value of the firm (Fama, 1980). Fama used the term
"employment capital" to incorporate not only the CEO's
current earnings but also the potential future earnings that would
reflect the CEO's tenure in office--and ultimately the record of
performance the executive is able to sustain. Thus, executives will
encounter a certain amount of pressure to perform because of its effect
on their employment capital, and may perceive or react to that pressure
in different ways under different circumstances.
Research has identified the existence of performance pressure among
a wide variety of work environments and groups (see, for example, Barnes
et al., 1983; Clancy and Krieg, 2001; Rossier, 2002). That research also
shows that pressure increases stress (Barnes et al., 1983; Ho, 1997),
and may affect intellectual performance and result in aberrant behavior
such as over-forecasting of company performance (Sochocki, 2000),
creative accounting (Shah, 1997), and fraud (Thompson, 1999).
A theoretical explanation for the relationship between performance
pressure and deviant behavior can be found in prospect theory, which
makes the case that an individual's risk propensity changes
according to achieved performance relative to target performance
(Kahneman and Tversky, 1979; March and Shapira, 1987). When individuals
are near or above target performance they tend to be risk-averse, but
when they are below target they tend to become risk-seeking. Managers
who can consistently deliver required (target) performance can continue
implementing their proven strategies, while managers who produce losses
or below industry-average performance will be tempted to adopt riskier
strategies in order to meet expectations. In short, desperation can be
expected to increase as the targeted performance level moves ever higher
relative to current performance (Reed et al., 2004).
In practice, this scenario is likely to play out in two different
sets of contextual circumstances: situations in which the risk of firm
failure is high, and situations in which the firm performs well and is
expected to do even better. In the case of sustained poor performance,
the likelihood of eventual firm failure directly imperils managerial
employment capital (Gilson, 1989, 1990), and may lead to displacement of
the incumbent management team even prior to a declaration of bankruptcy
(Daily and Dalton, 1995). Consistent with prospect theory, the need to
preserve employment capital as performance declines and the risk of
failure increases may lead managers to various acts of desperation,
including the dissemination of misleading financials designed to mask
the extent of the firm's decline.
However, it is not only the managers of firms experiencing high
levels of distress who are likely to perceive threats to their
employment capital and to act accordingly. Based on observations of past
high performance, expectations for future growth may simply project
historical growth rates into the future (Lakonishok et al., 1994; La
Porta, 1996), such that the performance target for high-growth firms
continually increases to higher and higher levels. In this variation of
the "no good deed goes unpunished" syndrome, managers are
faced with a loss-oriented framing context (Kahneman and Tversky, 1979)
in which a mere reproduction of current period performance, however good
in absolute terms, automatically translates into less-than-expected
future performance. Therefore, managers in this situation are likely to
perceive a threat to their employment capital, and are likely to adopt a
risk orientation favoring any strategies and other decisions necessary
to produce increasingly higher results (Kahneman and Tversky, 1979;
March and Shapira, 1987). The issuance of misleading disclosures would
be one such action that would both boost reported performance and
protect employment capital.
Hypothesis 1: The incidence of misleading disclosures will increase
as either the risk of firm failure or firm performance increases.
CEO Power
The extensive literature on CEO power suggests a concern for
maintenance of a "healthy" balance of power between the CEO
and the board (e.g., Daily and Schwenk, 1996; Morse, 2002). This focus
is not a theoretical abstraction. Empirical evidence suggests that high
CEO power is associated with lower firm performance (Pearce and Zahra,
1991), dominance of the strategic agenda (Golden and Zajac, 2001), and
investment distortions (Mahoney et al., 1997). The primary reason for
these findings seems to be that, in general, high CEO power leads to
executive entrenchment (Sundaramurthy et al., 1997) and the possibility
of what Diamond (1993) referred to as "control rent
appropriation," or the accumulation of excessive perks or other
benefits of office.
Indicia of power are varied in the literature, but among those
commonly utilized are tenure (Finkelstein and Hambrick, 1989; Ocasio,
1994; Shen and Cannella, 2002) and managerial ownership (Finkelstein and
Hambrick, 1989; Pollock et al., 2002; Sundaramurthy et al., 1997).
Tenure is seen as increasing the power of the CEO via
intra-organizational influence and authority. In turn, oversight by the
board or other monitors may be less effective and the CEO's job
security is likely to increase, at least where threshold expectations
are met (Ocasio, 1994; Shen and Cannella, 2002). Consistent with this
line of analysis, Williams et al. (2005) report a positive relationship
between managerial tenure and illegal activity. Therefore,
longer-serving, and thus more powerful, CEOs are more likely to be able
to leverage their standing and relative independence of action by
issuing misleading disclosures designed to give the appearance of better
than actual performance. Doing so permits these CEOs to maintain their
power base and freedom from oversight by continuing to deliver results
(even though ephemeral).
Hypothesis 2: The incidence of misleading disclosures will increase
as CEO tenure increases.
Agency theory suggests that equity ownership facilitates incentive
alignment and therefore will suppress purely self-interested actions by
managers (Jensen and Meckling, 1976; Pollock et al., 2002). This is
undoubtedly true where managers own little or no stock and begin to
accumulate a position of some substance. But as executive ownership
increases from minimal levels, the question remains whether, at higher
levels of ownership, incentive alignment benefits from incremental
increases in ownership outweigh the possibility of entrenchment. In
other words, for CEOs who already own a significant block of stock, will
adding more increase their incentives or only their voting power?
Empirical evidence, in fact, suggests a curvilinear relationship in
which any incentive alignment benefits accrue at low levels of ownership
but level off and decline as more equity is accumulated (McConnell and
Servaes, 1990; Morck et al., 1988). Thus, in terms of the implications
of CEO power, higher levels of ownership may increase the likelihood of
entrenchment (Finkelstein and Hambrick, 1989) and lead to lower firm
returns (McConnell and Servaes, 1990; McWilliams, 1990).
Applying this logic to the case of misleading disclosures leads to
the conclusion that either low or high levels of CEO ownership will be
associated with a greater likelihood of misleading disclosures. At low
levels of ownership, executive interests are not aligned with those of
shareholders (Jensen and Meckling, 1976) and the executive lacks any
power base associated with ownership that might permit him or her to
avoid questions concerning less than expected performance. By contrast,
at higher levels of ownership, power provides the means to mislead and
greater equity holdings provide the incentive to boost results and
(presumably) share prices (Finkelstein and Hambrick, 1989; McConnell and
Servaes, 1990).
Hypothesis 3: There is a curvilinear relationship between CEO stock
ownership and the production of misleading disclosures, such that
misleading disclosures are more likely to occur at either lower or
higher levels of CEO stock ownership.
The Moderating Role of the Board
Recent research suggests that boards are exercising authority more
directly and becoming more involved in firm activities and decision
making (Buchholtz et al., 2005; Golden and Zajac, 2001; Westphal and
Fredrickson, 2001; Zahra et al., 2005). This development is consistent
with the board's legal duties and with agency theory, both of which
assert that the board's primary responsibility is that of oversight
and control (Deutsch, 2005; Fama, 1980; Walsh and Seward, 1990). Key to
the board's ability to effectively oversee and control managerial
activities, however, is its independence from management (Daily and
Schwenk, 1996; Johnson et al., 1996). According to Johnson et al.,
"Directors who are personally influenced by the CEO ... may be less
effective monitors of firm management ... [and therefore] boards
comprised predominately ... of independent directors are expected to
more effectively monitor management self-interest" (1996: 416).
Thus, the proportion of unaffiliated outsiders on the board typically
has been associated with improved monitoring (Daily and Schwenk, 1996;
Johnson et al., 1996; see also Johnson et al., 1993). Consistent with
agency theory, equity ownership by directors also is posited to increase
the likelihood that boards will actively monitor the behavior of
management (e.g., Hoskisson et al., 1994; Johnson et al., 1996; Johnson
et al., 1993).
Average director tenure also may serve to increase the board's
independence and authority, in part by reducing the immediacy of any
sense of obligation to the CEO (Boeker, 1992; Wade et al., 1990).
Director tenure facilitates the development of a richer base of
organizational knowledge (Fiske and Taylor, 1991; Golden and Zajac,
2001), permitting the board to reach its own conclusions rather than
relying upon management for explanation. Finally, as the board serves
for a longer period of time, it has the opportunity to develop, and to
be seen, as a separate source of power and authority within the firm.
Thus, increasing tenure is likely to empower the board and to reduce the
likelihood that misleading disclosures will be issued.
The relationship between the board and management implies that the
board's ability to monitor and control CEO behavior will decrease
the likelihood that management will succeed in issuing misleading
disclosures. Thus, outside directors, director stock ownership and
director tenure, all indicators of board independence, will act as
moderating variables. Where an independent board can exercise sufficient
direct control, managers are less likely to attempt to mislead, but
where board control is weak, we can expect that managers will be
increasingly likely to issue misleading information.
Hypothesis 4a: As board control increases, the relationship between
firm performance and the incidence of misleading disclosures will
decrease.
Hypothesis 4b: As board control increases, the relationship between
CEO power and the incidence of misleading disclosures will decrease.
METHODS
Sample and Data Collection
We constructed the sample from an electronic word search in Lexis/
Nexis Business News that identified reports of financial restatements
involving legal action or SEC inquiries into overly-aggressive or
misleading accounting practices, particularly those in which revenues or
earnings were overstated or inventory or debt was understated. Cases
involving purely technical corrections or those in which upward
revisions in sales or earnings were undertaken in accordance with
generally accepted accounting principles (in other words, cases in which
the original reports were less positive than justified) were excluded
from the sample. We selected the years between 1996 and 1999, inclusive,
as the timeframe for the study. These years corresponded with generally
increasing economic activity and market performance, during which
expectations were high and steadily rising. The years from 2000 to the
present were excluded because of the advent of the bear market beginning
in approximately March 2000, the effect of which may have been to change
the standards of performance evaluation applied to firms and their
managers, and therefore to alter managerial incentives.
We then sought to identify matching organizations based upon each
primary sample firm's four-digit SIC code, total assets, and number
of employees. This design controls for inter-firm and
extra-organizational influences, specifically those relating to shared
industry and environmental effects and size-related advantages or
disadvantages. Data were matched based upon each firm's assets and
employees in the year immediately preceding the primary sample's
restatement period. Assets and employees were used as match criteria
because these totals were less likely than earnings to have been subject
to manipulation or misstatement. We then conducted a word search for the
matching firms in order to ensure that they had not restated earnings.
Matches were identified for all but two of the primary-sample firms,
yielding a total sample of 140 companies, comprised of 70 restating
firms and 70 non-restating firms. The same one-year lag procedure for
data collection was also utilized in the matching process. Full data
were gathered for each company (both restating and non-restating) for
the year immediately preceding the restatement period.
Variables
As indicated, the dependent measure was the incidence of a
restatement to prior years' earnings. This variable was coded
"1" for firms who restated earnings and "0" for
those who did not.
The independent measures included multiple indicia of performance
pressure, executive power, and board control. For performance pressure,
we included each firm's return on assets, total market return
(price appreciation and dividends), and bankruptcy risk for the year
preceding the restatement year. The return measures indicate the extent
of positive performance pressure, which, as theorized above, may lead to
increasingly high performance targets. Conversely, bankruptcy risk was
included in order to capture the notion of negative performance. We
utilized Altman's Z score (Altman, 1983, 1988) as a proxy for this
construct, a discriminant function that predicts the likelihood of
subsequent bankruptcy based on a number of preceding financial
indicators. As developed in Altman's work, lower Z scores indicate
higher bankruptcy risk.
CEO tenure and equity ownership percentage, the measures of CEO
power, were calculated as the CEO's years of service in that
capacity and shares owned divided by total shares outstanding. In the
case of the latter, an additional squared term was calculated in order
to test the hypothesized curvilinear relationship (Finkelstein and
Hambrick, 1989; McConnell and Servaes, 1990).
Board power, as suggested by the discussion above, involved the use
of three measures. Outside director percentage was calculated as the
ratio of unaffiliated outsiders to total board members, and equity
ownership was calculated by finding the average shares owned by
directors, both of which measures follow previous research (e.g.,
Hoskisson et al., 1994; Johnson et al., 1996). Average board tenure was
entered in order to address the power of the board relative to that of
the CEO (Golden and Zajac, 2001).
Four controls were employed: total assets, number of employees, CEO
contingent compensation and CEO duality. Firm size has been a generally
accepted control variable in strategic management research (e.g., Singh,
1986). Although assets and employees were matching criteria, we viewed
it as important to enter these values as controls in order to protect
against any residual between-pair variance and the influence that these
variables may have on any of the independent measures. We included a
measure of contingent compensation, calculated on the basis of each
CEO's proportion of options and bonuses to salary, which is
analogous to previously utilized measures of pay structure (Carpenter
and Sanders, 2002). This variable permits us to capture and control for
the extent to which a CEO would have a direct financial incentive to
boost reported performance. Finally, duality, the simultaneous vesting
in one individual of the positions of CEO and board chair, also
intuitively relates to the balance of power between the board and the
CEO. However, the existing literature has failed to establish
unambiguous effects for duality (e.g., Johnson et al., 1996; Mahoney et
al., 1997). Therefore, we did not believe a clear theoretical
justification for its inclusion as an independent variable existed, and
instead decided to include it as a control for any potential power
effects.
Analytical Method
Given the use of a dichotomous dependent variable, logistic
regression represented the most appropriate methodology for testing the
hypothesized effects. This technique offers the benefit of avoiding
violation of standard multiple regression assumptions, given the
presence of a dichotomous dependent variable. Testing followed a
hierarchical procedure, starting with a regression model including only
the controls. A second regression model, including the control and
independent variables, was estimated and compared to that obtained in
the control model. A significant increment over the control model
supports the validity of the main effects model and the interpretation
of the individual coefficients (Cohen and Cohen, 1983).
After testing for main effects, we constructed two additional
regression equations, the first of which added product terms calculated
by multiplying the board variables found to be significant from the
baseline model with each of the significant independent variables
measuring performance and power. The second model incorporated the
squared CEO ownership term to test for curvilinearity. Analysis began
with confirmation that each additional model significantly incremented
the main effects model and that the interaction and squared term models
significantly incremented the main effects model (Cohen and Cohen, 1983;
Jaccard et al., 1990).
RESULTS
Following the procedures outlined above, we obtained results
providing at least partial support for most of our hypotheses. In this
section, we will discuss the results and provide additional
methodological detail for each hypothesis in turn. We begin by noting
that Table 1 presents the correlations and descriptive statistics for
the variables used in this study, and Table 2 presents the separate
regression results for each of the models employed in the study. As
shown in Table 2, the control model explains less than 10% of total
variance (Nagelkerke [R.sup.2] = .08), although the contingent
compensation variable is positive and significant (b = .362, p <
.05). Model 2, the main effects model, significantly incremented Model 1
(Nagelkerke [R.sup.2] = .384, F = 12.769, p < .001), thereby
supporting the validity of interpreting individual coefficients.
Hypothesis 1 predicted that employment capital risk, resulting from
either bankruptcy risk or high firm performance, would increase the
likelihood of misleading disclosures. Market return was positively
associated with restatement activity (b = .011, p < .01), while
return on assets, although positively signed as expected failed to
attain statistical significance. Hypothesis 1 thus receives partial
support, at least in the case of market return.
Hypotheses 2 and 3 were concerned with the relationship between CEO
power and misleading disclosures, respectively defined in terms of
tenure and ownership. As indicated in Model 2, Table 2, CEO tenure is
not significantly related to the issuance of misleading disclosures (b =
.001, n.s.), thereby failing to support Hypothesis 2. CEO ownership, on
the other hand, is positively and curvilinearly related to misleading
disclosures, as shown in Models 2 and 4 of Table 2. The main effect
coefficient (b = .037, p < .05) indicates an entrenchment effect as
ownership increases, and the test of curvilinearity in Model 4
establishes the U-shaped relationship (b = .003, p < .05) consistent
with increasing disclosure manipulation at either low or high levels of
ownership. Thus, Hypothesis 3 is supported.
Finally, hypotheses 4a and 4b predicted that board control would
moderate the foregoing relationships by increasing the likelihood of
misleading disclosures when control was low and decreasing misleading
disclosures when control was high. From Model 2, we determined that a
significant main effect existed only for average board tenure. Neither
outside board percentage nor equity ownership attained statistical
significance. Using board tenure as the basis for the test of
moderation, we calculated separate product terms by multiplying board
tenure by both CEO ownership and market return, the significant main
effects relating to employment capital risk and CEO power. These product
terms were entered in a separate regression, reported as Model 3.
As can be seen from Table 2, Model 3 significantly increments the
main effects model (Model 2), permitting individual coefficient
interpretation (F = 15.299, p < .001). The product term relating to
CEO ownership was not significant, but the board tenure-market return
interaction attained a high level of significance (b = .003, p <
.01). We can conclude, therefore, that CEO ownership exists as a
significant main effect unaffected by board influence.
Having established the existence of significant interaction terms,
we evaluated the form of the interaction at high and low levels of the
independent variables (Cohen and Cohen, 1983; Jaccard et al., 1990).
Decomposition of the initial results revealed that, as predicted, board
tenure was lower among restating firms with higher returns. In other
words, a positive relationship between firm performance and restated
earnings occurred only when board tenure was significantly lower than
that found at firms that did not restate earnings. Unexpectedly,
however, the converse held in cases of low firm returns: restating
companies had higher levels of board tenure than was true of the
matching companies. On balance, then, Hypothesis 4a receives partial
support with respect to the effect of board tenure among firms with high
market return levels.
DISCUSSION AND CONCLUSIONS
This research sought to extend our understanding of the phenomenon
of misleading disclosures. We relied upon agency theory (e.g., Jensen
and Meckling, 1976) and prospect theory (e.g., Kahneman and Tversky,
1979) to develop and test a model incorporating executives'
motivations to protect their employment capital and to exploit their
power. We also suggested that the existence of board control would
moderate the relationships between these factors and the incidence of
misleading disclosures. In this section we will discuss the research
implications of our findings, managerial implications, and the
limitations of this study and directions for future research.
Research Implications
Hypothesis 1 proposed that as employment capital was put at risk in
the presence of significant pressure to perform, executives would be
more likely to issue misleading disclosures in order to meet performance
expectations and thereby protect their current employment status and
future prospects. Our results confirmed these expectations, at least
with respect to high market returns, and are therefore consistent with
the tenets of prospect theory (Kahneman and Tversky, 1979). Return on
assets and bankruptcy risk were not statistically significant, although
their signs were in the anticipated direction. This pattern, with
significant results for market returns but not the other aspects of
performance, suggests that the principal source of pressure, or at least
the one to which managers are most sensitive, comes from the market.
Investors use already realized, and therefore objectively verifiable,
returns to set future performance targets that increase pressure on
managers. Alternatively, or perhaps additionally, executives themselves
may not view the internal return figures as sources of performance
pressure--perhaps because they know better than to place too much
emphasis upon such performance indices.
Hypotheses 2 and 3 examined the effects of CEO power, measured
respectively in terms of tenure and equity ownership, on the incidence
of misleading disclosures. CEO tenure did not emerge as a significant
predictor of misleading disclosures. However, our findings suggest that
the incidence of misleading disclosures is related to CEO ownership in
the form of a U-shaped curve, a pattern similar to that disclosed by
previous research investigating the effects of CEO equity (Finkelstein
and Hambrick, 1989; McConnell and Servaes, 1990). This result also is
broadly consistent with agency theory (Jensen and Meckling, 1976),
although with an important contingency for power effects. There is
indeed an incentive-alignment process in the present context, given that
misleading disclosures decrease as ownership increases from low levels.
But, the fact that the incidence of misleading disclosures increases
again after ownership reaches a certain level implies that we must be
sensitive to the entrenchment potential associated with ownership power.
Indeed, the positive relationship between the contingent compensation
control variable and misleading disclosures hints at the same problem:
ownership translates to power, which can lead to abuse. Collectively,
then, our findings suggest that the question of incentives must be
approached carefully, and must be tailored to maximize incentive effects
without also maximizing power.
Finally, Hypothesis 4 proposed that board control would decrease
the likelihood of misleading disclosures otherwise occurring as a result
of employment capital risk or CEO power. Board tenure was found to
interact significantly with performance, specifically the firm's
market return, but in a manner somewhat at variance with expectations.
High-return restating firms indeed had lower levels of board tenure than
their match counterparts, but at lower return levels board tenure
actually was higher among restating companies than among non-restating
firms. The implication here is that board tenure reduces the influence
of performance pressure when performance is high but may accentuate
pressure when performance is low.
To some extent, this may reflect appropriate board activity: boards
should, as part of their oversight role, seek to stimulate improved
performance and to hold executives accountable. The problem arises,
however, in the present context when executives resort to unethical
means to achieve the results desired, and when boards do not inquire too
closely into how those results were achieved. Gilson (1989, 1990)
documented that boards also are concerned about their reputations and
employment capital, just as we describe here in relation to CEOs, and
that directors of failing firms suffer significant and sustained losses
to future employability. It may not be surprising, then, if, in firms
with lower returns, boards push executives to deliver improved results,
and if the executives sometimes rely on misleading disclosures to
accomplish that result. Nevertheless, this result also is troubling from
a governance perspective; ideally, boards always would both hold CEOs
accountable for performance standards and also investigate the means by
which that performance is attained.
Managerial Implications
In this section, we use a broad definition of
"managerial" implications to provide direction for firms
looking to strengthen their defenses against misbehavior. In short, we
are concerned here with the problem of managing the managers.
To begin, our results clearly support the general need to
strengthen boards and improve oversight (e.g., Deutsch, 2005; Zahra et
al., 2005). In particular, our work shows the importance of board tenure
as a means of increasing independence for this purpose. Long-serving
boards have the opportunity to learn the business at a substantive
level, which can help them identify questionable decisions and
activities as well as gain authority within the organization (Fiske and
Taylor, 1991; Golden and Zajac, 2001).
A second aspect of the board-CEO relationship is the role of the
board in moderating performance pressure. This study shows that board
tenure facilitated the process of reducing pressure in high-return firms
that seemed to lead to misleading disclosures in firms without the same
level of board authority. Our results also are cautionary, however:
board tenure appeared to increase the likelihood of misleading
disclosures among low-return firms. Less successful firms thus appear to
need help in striking a balance between demanding performance and yet
not, at the same time, inducing the kinds of desperation that lead to
unethical or illegal actions. Obviously, this is a difficult balance to
strike, and precisely how to achieve this must remain a matter for
future research, to which we now turn.
Limitations and Future Research
As is true of any study, limitations in design and orientation
limit the generalizability of the results obtained and leave room for
additional work to extend understanding and answer remaining questions.
Most obvious in this regard is our study's limited behavioral
inquiry. The problem at issue here has a significant behavioral
component, leaving many areas of inquiry open beyond the question of
governance and control. Aspects of personality and motivation, along
with many other similar constructs, could be investigated.
Somewhat related to this issue is the question of proper
compensation design. Our study did not directly investigate the
relationship between CEO pay and the issuance of misleading disclosures
beyond including a gross measure of contingent compensation as a control
variable. Finer grained measures might be important subjects of study.
For example, as our results suggest, it would be important to understand
the trade-offs inherent between incentive structures and power
accumulation. Compensation patterns also might provide some insight into
the problem of moderating performance pressure. Coupled with effective
boards, the proper incentive design could address many remaining
concerns surrounding this phenomenon.
In addition to compensation, the question of employment capital
effects can and should be investigated further. Our results showed that
executives of poorly performing firms did not respond by increasing the
issuance of misleading disclosures, yet high levels of board tenure in
those same firms appeared to contribute to such an increase. However,
absent consideration of board control high performers were associated
with a greater likelihood of misleading disclosures. Greater
understanding of these relationships would be an important contribution.
Finally, we should note that the sample for this work was drawn
from the latter part of the 1990s, which was characterized by a strong
bull market. That single condition allowed us to examine the effects of
a uniform set of market expectations on the drivers and moderators of
misleading financial disclosures. While it provided us with the
opportunity for a simpler analysis and, consequently, a cleaner
interpretation of results, it clearly limited the generalizability of
our work. Therefore, future research needs to extend this study by
examining the antecedents of misleading financial disclosures in a
broader context that includes both bull- and bear-market conditions and,
thus, a full range of investor expectations and managerial motives.
* The authors wish to thank Barbara Chatburn and Janet Heter for
their diligent efforts in data collection. A previous version of this
research was presented at the 2003 Academy of Management Annual Meeting
in Seattle, Washington.
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William J. Donoher
Associate Professor of Management
Missouri State University
Richard Reed
Professor of Management and Operations
Washington State University
Table 1
Correlations and Descriptive Statistics
Variable Mean S.D. 1
1. Restatement ([double dagger]) .50 .50 1.00
2. Assets (In) 5.12 1.80 .01
3. Employees (In) .25 1.79 .03
4. Duality ([double dagger]) .72 .45 -.12
5. Cont. comp. 1.17 1.38 .21 **
6. ROA -2.65 29.65 .04
7. Z score 7.63 16.16 -.10
8. Mkt. return 35.32 233.42 .17 *
9. CEO tenure 8.46 8.36 -.16 ([dagger])
10. CEO own. pct. 8.79 16.51 .12
11. Board own. pct. 5.07 9.11 .02
12. Board tenure 7.39 5.18 -.31 ***
13. Outsider pct. .60 .21 .07
Variable 2 3
1. Restatement ([double dagger])
2. Assets (In) 1.00
3. Employees (In) .82 *** 1.00
4. Duality ([double dagger]) .15 ([dagger]) .12
5. Cont. comp. .18 * .11
6. ROA .33 *** .27 ***
7. Z score -.10 -.24 **
8. Mkt. return -.05 .03
9. CEO tenure .10 .15 ([dagger])
10. CEO own. pct. -.36 *** -.19 *
11. Board own. pct. -.24 ** -.29 ***
12. Board tenure .17 * .21 **
13. Outsider pct. .23 ** .06
Variable 4 5
1. Restatement ([double dagger])
2. Assets (In)
3. Employees (In)
4. Duality ([double dagger]) 1.00
5. Cont. comp. -.07 1.00
6. ROA -.04 .13
7. Z score -.13 .23 **
8. Mkt. return -.12 -.07
9. CEO tenure .28 *** -.02
10. CEO own. pct. .16 * -.19 *
11. Board own. pct. -.0l -.13
12. Board tenure .11 -.09
13. Outsider pct. .08 .08
Variable 6 7 8
1. Restatement ([double dagger])
2. Assets (In)
3. Employees (In)
4. Duality ([double dagger])
5. Cont. comp.
6. ROA 1.00
7. Z score .15 ([dagger]) 1.00
8. Mkt. return .05 -.07 1.00
9. CEO tenure .15 ([dagger]) -.03 -.04
10. CEO own. pct. -.07 -.04 .01
11. Board own. pct. -.15 ([dagger]) .01 -.07
12. Board tenure .17 * -.04 .01
13. Outsider pct. -.01 -.06 -.09
Variable 9 10
1. Restatement ([double dagger])
2. Assets (In)
3. Employees (In)
4. Duality ([double dagger])
5. Cont. comp.
6. ROA
7. Z score
8. Mkt. return
9. CEO tenure 1.00
10. CEO own. pct. .08 1.00
11. Board own. pct. -.15 ([dagger]) -.04
12. Board tenure .50 *** .01
13. Outsider pct. -.07 -.09
Variable 11 12 13
1. Restatement ([double dagger])
2. Assets (In)
3. Employees (In)
4. Duality ([double dagger])
5. Cont. comp.
6. ROA
7. Z score
8. Mkt. return
9. CEO tenure
10. CEO own. pct.
11. Board own. pct. 1.00
12. Board tenure -.11 1.00
13. Outsider pct. .04 -.16 * 1.00
N = 140. ([double dagger]) = Coded 0 (no) or 1 (yes).
([dagger]) p < .10, * p < .05, ** p < .01, *** p < .001.
Table 2
Results of Logistic Regression Analyses
Variable Model l Model 2
Controls:
Assets (ln) -.121 .361
Employees (ln) .127 -.153
Duality ([double dagger]) -.486 -.752
Contingent comp. .362 .537 **
Independent Variables:
ROA .002
Z score -.029
Market return .011 **
CEO tenure .001
CEO own. pct. .037 *
Board own. pct. .022
Board tenure -.173 **
Outside pct. -.441
Interactions:
Bd. ten. x Mkt. ret.
Bd. ten. x CEO own. pct.
Curvilinear relationship:
CEO own. pct. squared
Constant .520 -.762
-2LL 184.137 139.239
[DELTA]-2LL 44.898 ***
Hit rate .597 .774
Nagelkerke [R.sup.2] .080 .384
[DELTA] Nagelkerke [R.sup.2] .304
F statistic 12.769 ***
Variable Model 3 Model 4
Controls:
Assets (ln) .341 .323
Employees (ln) -.031 -.139
Duality ([double dagger]) -.815 -.520
Contingent comp. .542 ** .595 **
Independent Variables:
ROA .003 .001
Z score -.029 -.031
Market return -.007 .012
CEO tenure -.016 .015
CEO own. pct. .038 -.087
Board own. pct. .021 .031
Board tenure -.263 ** -.194 **
Outside pct. -.557 -1.119
Interactions:
Bd. ten. x Mkt. ret. .003 **
Bd. ten. x CEO own. pct. -.002
Curvilinear relationship:
CEO own. pct. squared .003 *
Constant -.013 -.037
-2LL 127.459 135.214
[DELTA]-2LL 11.780 ** 4.085 *
Hit rate .797 .752
Nagelkerke [R.sup.2] .46